13

INTRODUCTION

By 1976, computers had been around for decades, but they were typically the size of a large room and just as expensive. To use one, you had to learn a programming language. On April 1, 1976, Steve Jobs, Steve Wozniak, and Ron Wayne started a company to make personal computers. On January 3, 1977, Jobs and Wozniak incorporated without Wayne, buying his 10 per cent share of the company for $800 (Linzmayer, 1999).

On December 12, 1980, Apple Computer, Inc. went public; its stock sold for $22 per share (FundingUniverse, 2009). Had you bought Apple’s stock when the company went public and held it until today, you would have earned an annual return of about 14.5 per cent.

Typically, an inventor has a great idea, then teams up with—or becomes—an entrepreneur. The entrepreneur’s job is to build a company that can make the invention a reality. The company needs to find the resources to make the product and sell it widely enough to pay for those resources and to create a profit, making the whole effort worthwhile. No matter how great the idea is, if it can’t be done profitably, it can’t be done. The personal computer had to be produced and sold to be widely used and useful.

As an investor, you buy stocks hoping to share in corporate profits, benefiting directly from the inventive vitality of the economy and participating in economic growth. Understanding what stocks are, where they come from, what they do, and how they have value will help you decide how to include stocks in your investment portfolio and how to use them to reach your investment goals.

REFERENCES

FundingUniverse. (2009). “Company Histories: Apple Computer, Inc.” Retrieved from: http://www.fundinguniverse.com/company-histories/Apple-Computer-Inc- Company-History.html.

Linzmayer, R. (1999). Apple Confidential: The Real Story of Apple Computer, Inc. San Francisco: No Starch Press.

13.1 STOCKS AND STOCK MARKETS

Resources have costs, so a company needs money, or capital, which is also a resource. To get that start-up capital, the company could borrow or it could offer a share of ownership, or equity, to those who chip in capital.

If the costs of debt (interest payments) are affordable, the company may choose to borrow, which limits the company’s commitment to its capital contributor. When the loan matures and is paid off, the relationship is over.

If the costs of debt are too high, however, or the company is unable to borrow, it seeks equity investors willing to contribute capital in exchange for an unspecified share of the company’s profits at some time in the future. In exchange for taking the risk of no exact return on their investment, equity investors get a say in how the company is run.

Stock represents those shares in the company’s future and the right to a say in how the company is run. The original owners—the inventor(s) and entrepreneur(s)—choose equity investors who share their ideals and vision for the company. Usually, the first equity investors are friends, family, or colleagues; this allows the original owners freedom of management. At that point, the corporation is privately held, and the company’s stock may be traded privately between owners. There may be restrictions on selling the stock, as is often the case for a family business, so that control stays within the family.

If successful, however, eventually the company needs more capital to grow and remain competitive. If debt is not desirable, then the company issues more equity, or stock, to raise capital. The company may seek out an angel investor, venture capital firm, or private equity firm. Such investors finance companies in the early stages in exchange for a large ownership and management stake in the company. Their strategy is to buy a significant stake when the company is still “private” and then realize a large gain, typically when the company goes public. The company may also seek a buyer, perhaps a competitive or complementary business.

Alternatively, the company may choose to go public, selling shares of ownership to investors in the public markets. Theoretically, this means sharing control with random strangers because anyone can purchase shares traded in the stock market. It may even mean losing control of the company. Founders can be fired, as Steve Jobs was from Apple in 1985 (although he returned as CEO in 1996).

Going public requires a profound shift in corporate structure and management. Once a company is publicly traded, it falls under the regulatory scrutiny of federal and provincial governments, and must regularly file financial reports and analysis. It must broaden participation on the board of directors and allow more oversight of management. Companies go public to raise large amounts of capital to expand products, operations, markets, or to improve or create competitive advantages. To raise public equity capital, companies need to sell stock, and to sell stock they need a market. That’s where the stock markets come in.

Primary and Secondary Markets

The private corporation’s board of directors—shareholders elected by the shareholders—must authorize the number of shares that can be issued. Since issuing shares means opening the company up to more owners, or sharing it among more people, only the existing owners have the authority to do so.

Those authorized shares are then issued through an initial public offering (IPO). At that point the company goes public. The IPO is a primary market transaction, which occurs when the stock is initially sold and the proceeds go to the company issuing the stock. After that, the company is publicly traded; its stock is outstanding, or publicly available. Then, whenever the stock changes hands, it is a secondary market transaction. The owner of the stock may sell shares and realize the proceeds. When most people think of “the stock market,” they are thinking of the secondary markets.

The existence of secondary markets makes the stock a liquid or tradable asset, which reduces its risk for both the issuing company and the investor buying it. The investor is giving up capital in exchange for a share of the company’s profit, with the risk that there will be no profit or not enough to compensate for the opportunity cost of sacrificing the capital. The secondary markets reduce that risk to the shareholder because the stock can be resold, allowing the shareholder to recover at least some of the invested capital and to make new choices with it.

Meanwhile, the company issuing the stock must pay the investor for assuming some of its risk. The less that risk is, because of the liquidity provided by the secondary markets, the less the company has to pay. The secondary markets decrease the company’s cost of equity capital.

A company hires an investment bank to manage its initial public offering of stock. For efficiency, the bank usually sells the IPO stock to institutional investors. Usually, the original owners of the corporation keep large amounts of stock as well.

What does this mean for individual investors? Some investors believe that after an initial public offering of stock, the share price will rise because the investment bank will have initially underpriced the stock in order to sell it. This is not always the case, however. Share price is typically more volatile after an initial public offering than it is after the shares have been outstanding for a while. The longer the company has been public, the more information is known about the company, and the more predictable its earnings, and thus its share price, are (Lowery, Officer, and Schwert, 2009).

When a company goes public, it may issue a relatively small number of shares. Its market capitalization—the total dollar value of its outstanding shares—may therefore be small. The number of individual shareholders, mostly institutional investors and the original owners, also may be small. As a result, the shares may be “thinly traded”—that is, traded infrequently or in small amounts.

Thinly traded shares may add to the volatility of the share price. One large shareholder deciding to sell could cause a decrease in the stock price, for example, whereas for a company with many shares and shareholders, the actions of any one shareholder would not be significant. As always, diversification—in this case, of shareholders—decreases risk. Thinly traded shares are less liquid and more risky than shares that trade more frequently.

Common, Preferred, and Foreign Stocks

A company may issue common stock or preferred stock. Common stock is more prevalent. All companies issue common stock, whereas not all issue preferred stock. The differences between common and preferred have to do with the investor’s voting rights, risk, and dividends.

Common stock allows each shareholder voting rights—one vote for each share owned. The more shares you own, the more you can influence the company’s management. Shareholders vote for the company’s directors, who provide policy guidance for and hire the management team that directly operates the corporation. After several corporate scandals in the early twenty-first century, some shareholders have assumed a more active voting role.

Common stockholders assume the most risk of any corporate investor. If the company encounters financial distress, its first responsibility is to satisfy creditors, then the preferred shareholders, and then the common shareholders. Thus, common stocks provide only residual claims on the value of the company. In the event of bankruptcy, in other words, common shareholders get only the residue—whatever is left after all other claimants have been compensated.

Common shareholders share the company’s profit after interest has been paid to creditors and a specified share of the profit has been paid to preferred shareholders. Common shareholders may receive all or part of the profit in cash—the dividend. The company is under no obligation to pay common stock dividends, however. The management may decide that the profit is better used to expand the company, to invest in new products or technologies, or to grow by acquiring a competitor. As a result, the company may pay a cash dividend only in certain years or not at all.

Shareholders investing in preferred stock, on the other hand, give up voting rights but get less risk and more dividends. Preferred stock typically does not convey voting rights to the shareholder. As noted above, preferred shareholders have a superior claim on the company’s assets in the event of bankruptcy. They get their original investment back before common shareholders, but after creditors.

Preferred dividends are more of an obligation than common dividends. Most preferred shares are issued with a fixed dividend as cumulative preferred shares. This means that if the company does not create enough profit to pay its preferred dividends, those dividends ultimately must be paid before any common stock dividend.

For the individual investor, preferred stock may have two additional advantages over common stock:

1. Less volatile prices
2. More reliable dividends

As the company goes through its ups and downs, the preferred stock price will fluctuate less than the common stock price. If the company does poorly, preferred stockholders are more likely to be able to recoup more of their original investment than common shareholders because of their superior claim. If the company does well, however, preferred stockholders are less likely to share more in its success because their dividend is fixed. Preferred shareholders are thus exposed to less risk, protected by their superior claim and fixed dividend. The preferred stock price reflects less of the company’s volatility.

Because the preferred dividend is more of an obligation than the common dividend, it provides more predictable dividend income for shareholders. This makes the preferred stock less risky and attractive to an investor looking for less volatility and more regular dividend income.

The following table summarizes the differences between common stock and preferred stock.

 

Each of these terms names a stock’s relationship to the market and to investors. For example, an investor who wants to invest in stocks but wants to minimize economic risk would include defensive stocks along with some blue chips. Implicit is its potential for price growth, risk, or role in a diversified portfolio.

 

REFERENCES

Fama, E. F., and K. R. French. (1992). “The Cross-section of Expected Stock Returns.” Journal of Finance 47: 427–486.

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13.3 COMMON MEASURES OF VALUE

A corporation creates a return for investors by creating earnings. Those earnings may be paid out in cash as a dividend or retained as capital by the company. A company’s ability to create earnings is watched closely by investors because the company’s earnings are the investor’s return.

A company’s earnings potential can be tracked and measured, and several measurements are expressed as ratios. Mathematically, as discussed in Chapter 3 “Financial Statements,” a ratio is simply a fraction. In investment analysis, a ratio provides a clear means of comparing values. Three kinds of ratios important to investors are return ratios, growth ratios, and market value ratios.

The ratios described here are commonly presented in news outlets and websites where stocks are discussed (e.g., the Toronto Stock Exchange and the NASDAQ Stock Market), so chances are you won’t have to calculate them yourself. Nevertheless, it is important to understand what they mean and how to use them in your investment thinking.

Return Ratios

One of the most useful ratios in looking at stocks is the earnings per share (EPS): the dollar value of the earnings per each share of common stock. It calculates the company’s earnings, or the portion of a company’s profit allocated to each outstanding share of common stock. The calculation lets you see how much you benefit from holding each share. Here is the formula for calculating EPS:

EPS = (net income − preferred stock dividends)
        average number of common shares outstanding

The company’s earnings are reported on its income statement as net income, so a shareholder could easily track earnings growth. However, the EPS allows you to make a direct comparison to other stocks by putting the earnings on a per-share basis, creating a common denominator. Earnings per share should be compared over time and also compared to the EPS of other companies.

When a stock pays a dividend, that dividend is income for the shareholder. Investors concerned with the cash flows provided by an equity investment look at dividends per share (DPS) as a measure of the company’s ability and willingness to pay a dividend.

DPS = common stock dividends
             average number of common
          shares outstanding

Another measure of the stock’s usefulness in providing dividends is the dividend yield, which calculates the dividend as a percentage of the stock price. It is a measure of the dividend’s role as a return on investment: for every dollar invested in the stock, how much is returned as a dividend, or actual cash payback? An investor concerned about cash flow returns can compare companies’ dividend yields.

dividend yield = dividend per share (in dollars)
                              price per share (in dollars)

Earnings are either paid out as dividends or are retained by the company as capital. That capital is used by the company to finance operations, capital investments such as new assets for expansion and growth, or repayment of debt.

The dividend is the return on investment that comes as cash while you own the stock. Some investors see the dividend as a more valuable form of return than the earnings that are retained as capital by the company. It is more liquid, since it comes in cash and comes sooner than the gain that may be realized when the stock is sold (more valuable because time affects value). It is the “bird in the hand,” perhaps less risky than waiting for the eventual gain from the company’s retained earnings.

Some investors see a high dividend as a sign of the company’s strength, indicative of its ability to raise ample capital through earnings. Dividends are a sign that the company can earn more capital than it needs to finance operations, make capital investments, or repay debt. Thus, dividends are capital that can be spared from use by the company and given back to investors.

Other investors see a high dividend as a sign of weakness, indicative of a company that cannot grow because it is not putting enough capital into expansion and growth or into satisfying creditors. This may be because it is a mature company operating in saturated markets, a company stifled by competition, or a company without the creative resources to explore new ventures.

As an investor, you need to look at dividends in the context of the company and your own income needs.

Growth Ratios

The more earnings are paid out to shareholders as dividends, the less earnings are retained by the company as capital.

earnings = dividends + capital retained

Since retained capital finances growth, the more earnings are used to pay dividends, the less earnings are used to create growth. Two ratios that measure a company’s choice in handling its earnings are the dividend payout rate and the retention rate. The dividend payout rate compares dividends to earnings, while the retention rate compares the amount of capital retained to earnings.

The dividend payout rate equals the dividend as a percentage of earnings.

dividend payout rate = dividends / earnings

The retention rate equals the retained capital as a percentage of earnings.

retention rate = capital retained / earnings

Because earnings = dividends + capital retained, then 100 per cent of earnings = dividend payout + retention rate.

If a company’s dividend payout rate is 40 per cent, then its retention rate is 60 per cent; if it pays out 40 per cent of its earnings in dividends, then it retains 60 per cent of them.

Since Microsoft has earnings of $15.3 billion and dividends of $4.68 billion, it must retain $10.62 billion of its earnings. So, for Microsoft,

dividend payout rate = 4.68 billion/15.3 billion = 30.59%

retention rate = 10.62 billion/15.3 billion = 69.41%

There is no benchmark dividend payout or retention ratio for every company; they vary depending on the age and size of the company, industry, and economic climate. These numbers are useful, however, to get a sense of the company’s strategy and to compare it to competitors.

A company’s value lies in its ability to grow and to increase earnings. The rate at which it can retain capital—that is, earn it and not pay it out as dividends—is a factor in determining how fast it can grow. This rate is measured by the internal growth rate and the sustainable growth rate. The internal growth rate answers the question, “How fast could the company grow (increase earnings) without any new capital, without borrowing or issuing more stock?” Given how good the company is at taking capital and turning it into assets and using those assets to create earnings, the internal growth rate looks at how fast the company can grow without any new borrowing or new shares issued.

The sustainable growth rate answers the question, “How fast could the company grow without changing the balance between using debt and using equity for capital?” Given how good the company is at taking capital and turning it into assets and using those assets to create earnings, the sustainable growth rate looks at how fast the company can grow if it uses some new borrowing, but keeps the balance between debt and equity capital stable.

Both growth rates use the retention rate as a factor in allowing growth. The fastest rate of growth could be achieved by having a 100 per cent retention rate—that is, by paying no dividends and retaining all earnings as capital.

An investor who is not using stocks as a source of income, but rather for their potential gain, may look for higher growth rates (evidenced by a higher retention rate and a lower dividend payout rate). An investor looking for income from stocks would instead be attracted to companies offering a higher dividend payout rate and a lower retention rate (despite lower growth rates).

Market Value Ratios

While return and growth ratios are measures of a company’s fundamental value, and therefore the value of its stocks, the actual stock price is affected by the market. Investors’ demand can result in the under- or overpricing of a stock, depending on its attractiveness in relation to other investment choices or opportunity cost.

A stock’s market value can be compared with that of other stocks. The most common measure for doing so is the price-to-earnings ratio (P/E). The price-to-earnings ratio is calculated by dividing the price per share (in dollars) by the earnings per share (in dollars). The result shows the investment needed for every dollar of return that the stock creates.

P/E = price per share / earnings per share

For Microsoft, for example, the price per share is around $24 and the EPS is $1.70, so the P/E = 24.00/1.70 = $14.12. This means that the price per share is around fourteen times bigger than the earnings per share.

The larger the P/E ratio, the more expensive the stock is and the more you have to invest to get one dollar’s worth of earnings in return. To get $1 of Microsoft’s earnings, you have to invest around $14. By comparing the P/E ratio of different companies, you can see how expensive they are relative to each other.

A low P/E ratio could be a sign of weakness. Perhaps the company has problems that make it riskier going forward, even if it has earnings now, so the future expectations and thus the price of the stock is now low. Or it could be a sign of a buying opportunity for a stock that is currently underpriced.

A high P/E ratio could be a sign of a company with great prospects for growth and so a higher price than would be indicted by its earnings alone. On the other hand, a high P/E could indicate a stock that is overpriced and has nowhere to go but down. In that case, a high P/E ratio would be a signal to sell your stock.

How do you know if the P/E ratio is “high” or “low”? You can compare it to other companies in the same industry or to the average P/E ratio for a stock index of similar-type companies based on company size, age, debt levels, and so on. As with any of the ratios discussed here, this one is useful in comparison.

Another indicator of market value is the price-to-book ratio (P/B). Price-to-book ratio compares the price per share to the book value of each share. The book value is the value of the company that is reported “on the books”—the company’s balance sheet—using the intrinsic or original values of assets, liabilities, and equity. The balance sheet does not show the market value of the company’s assets, for example, or what they could be sold for today; it shows what they were worth when the company acquired them. The book value of a company should be less than its market value, which should have appreciated over time. The company should be worth more as times goes on.

P/B = price per share
          book value of
            equity per share

Since the price per share is the market value of equity per share, the P/B ratio compares the current market value of the company’s equity to its book value. If that ratio is greater than one, then the company’s equity is worth more than its original value, and the company has been increasing its value. If that ratio is less than one, then the company’s current value is less than its original value, so the value has been decreasing. A P/B of one would indicate that a company has just been breaking even in terms of value over the years.

The higher the P/B ratio, the better the company has done in increasing its value over time. You can calculate the ratio for different companies and compare them by their ability to increase value.

Table 13.3.1 provides a summary of the return, growth, and market value ratios.

Table 13.3.1 Ratios and Their Uses

Ratio	What It Measures
Earnings per Share (EPS)	Earning (in dollars) for every outstanding share of stock
Dividends per Share (DPS)	Dividend (in dollars) for every outstanding share of stock
Dividends Yield	Dividend (in dollars) returned for every dollar invested in the stock
Dividends Payout	Percentage of earnings retained as capital
Internal Growth Rate	The fastest rate of growth without using more debt or issuing more equity
Sustainable Growth Rate	The fastest rate of growth using more debt but without changing the balance of debt and equity
Price-to-Earnings Ratio (P/E)	The market value of each dollar’s worth of earnings
Price-to-Book Ratio (P/B)	The market value of the company’s equity compared to its book value

Ratios can be used to compare a company with its past performance, with its competitors, or with competitive investments. They can be used to project a stock’s future value based on the company’s ability to earn, grow, and be a popular investment. A company has to have fundamental value to be an investment choice, but it also has to have market value to have its fundamental value appreciated in the market and to have its price reflect its fundamental value.

 

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13.4 EQUITY STRATEGIES

The best stock strategy is to know what you are looking for (i.e., what kind of stock will fulfill the role you want it to play in your portfolio) and to do the analyses you need to find it. That is easier said than done, however, and it requires that you have the knowledge, skill, and data for stock analysis. Commonly used general stock strategies may be long term (returns achieved in more than one year) or short term (returns achieved in less than one year), but the strategies you choose should fit your investing horizon, risk tolerance, and needs. An important part of that strategy, as with financial planning in general, is to check your stock investments and re-evaluate your holdings regularly. How regularly depends on the long- or short-term horizon of your investing strategies.

Long-Term Strategies

Long-term strategies favour choosing a long-term approach to avoid the volatility and risk of market timing. For individual investors, a buy-and-hold strategy can be effective over the long run. The strategy is just what it sounds like: you choose the stocks for your equity investments, and you hold them for the long term. The idea is that if you choose wisely and your stocks are well diversified, over time you will do at least as well as the stock market itself. Though it suffers through economic cycles, the economy’s long-term trend is growth.

By minimizing the number of transactions, you can minimize transaction costs. Since you are holding your stocks, you are not realizing gains and are not paying gains tax. Thus, even if your gross returns are not spectacular, you are minimizing your costs and maximizing net returns. This strategy is optimal for investors with a long horizon, low risk tolerance, and little need for liquidity in the short term.

Another long-term strategy is dollar-cost averaging. The idea of dollar-cost averaging is that you invest in a stock gradually by buying the same dollar amount of the same stock at regular intervals. This is a way of negating the effects of market timing. By buying at regular intervals, you will buy at times when the price is low and when it is high, but over time your price will average out. Dollar-cost averaging is a way of avoiding a stock’s price volatility because the net effect is that you buy the stock at its average price.

An investor uses dollar-cost averaging when regular payroll deductions are made to fund defined contribution retirement plans. The same amount is contributed to the plan in regular intervals and is typically used to purchase the same set of specified assets.

A buy-and-hold or dollar-cost averaging strategy only makes sense over time because both assume a long time horizon in order to “average out” volatility, making them better than other investment choices. If you have a long-term horizon—as with a retirement plan, for example—those strategies can be quite effective. However, market or economic cycles can be long too, so you need to think about whether your “long-term” horizon is likely to outlast or be surpassed by the market’s cycle, especially as you near your investment goals.

Direct investment and dividend reinvestment are ways of buying shares directly from a company without going through a broker. This allows you to avoid brokerage commissions. Direct investment means purchasing shares from the company, while dividend reinvestment means having your dividends automatically invested in more shares (rather than being sent to you as cash). Dividend reinvestment is also a way of building up your equity in the stock by reinvesting cash that you might otherwise spend.

The advantage of direct investment and dividend reinvestment is primarily the savings on brokers’ commissions. You can also buy fractional shares—that is, less than a whole share—and there is no minimum amount to invest, as there can be with brokerage transactions. The disadvantage is that by having funds automatically reinvested, you are not actively deciding how they should be invested and thus may be missing better opportunities.

Indexing is a passive long-term investment strategy to invest in index funds as a diversified asset rather than select stocks. Instead of choosing individual large cap companies, for example, you could invest in the S&P 500’s index fund, which would provide more diversification for only one transaction cost than you could get picking individual securities. The disadvantage to indexing is that you do not enjoy the potential of individual stocks producing above-average returns.

Table 13.4.1 summarizes long-term stock strategies.

Short-Term Strategies

Short-term stock strategies rely on market timing to earn above-average returns. Some advisers believe that the stock market fluctuates between favouring value stocks and favouring growth stocks. That is, the market will go through cycles when value stocks that are temporarily underpriced outperform stocks of companies poised for higher growth, and vice versa. If true, you would want to weight your portfolio with growth stocks when they are favoured and with value stocks when they are favoured.

This value-growth weighting strategy relies on market timing, which is difficult for the individual investor to harness. It also relies on correctly identifying growth and value stocks and market trends in their favour, complicating the process of market timing even further.

Day trading is a very short-term strategy of taking and closing a position in a day or two. Literally, it means buying in the morning and selling in the afternoon. Day trading became popular in the 1990s when stock prices were riding the tide of the tech stock bubble. At that time, it was possible to hold a stock for just a few hours and earn a gain. Technology, especially the Internet, also made real-time quotes and other market data available to individual investors at a reasonable cost. At the same time, Internet and discount brokers drove down the costs of trading.

Day trading declined, but did not die, after the tech bubble burst. It turns out that in a bubble, any strategy can make money, but when market volatility is more closely related to earnings potential and fundamental value, there is no alternative to doing your homework, knowing as much as possible about your investments, and making appropriate strategic choices.